Sunday, January 22, 2006

One of Wall Street’s Finest, Indeed

I make fun of those I call “Wall Street’s Finest”—the brokerage firm employees who call themselves “analysts”—so frequently that it might appear I have no use for any analyst working for any brokerage firm anywhere.

This, of course, is not true.

I started on Wall Street as just such an analyst, but very low on the totem pole, being one of those junior assistants whose job it is to construct the vast Excel spreadsheet models which form the backbone of every research report, good or bad, coming out of every broker on the Street.

Except in those days we didn’t have Excel spreadsheets: we had a centralized computer center where strange FORTRAN-literate employees created earnings models on mainframe computers, using our hand-scratched numbers.We'd get a ream of computer paper back from the FORTRAN guys, look at pages and pages of numbers, make adjustmentss and send it back. And repeat the process any number of times, until we had a nice-looking computer-generated forecast that was basically meaningless by the time it was done.

Eventually we acquired something totally new: personal computers, which came with a cool spreadsheet program called “Lotus 1-2-3.”What this revolutionary, time-saving device did was allow me to spend all my waking hours experimenting with complex formulas, typing in numbers, hitting the "recalc" button and playing with secretary-style formatting techniques in order to create a computer-generated forecast that was, likewise, basically meaningless by the time it was done.

Garbage in, garbage out, as they say.

Which is why I find most Wall Street “models” to be pretty much nonsense, at least so far as the precision that is implied in an earnings forecast of, say, $3.28 per share in 2008. (Why not just round to the nearest nickel, or dime, or quarter?)

A good example of the garbage-in, garbage-out school of earnings models relates to Nextel, which we looked at a few years ago when that company was coming out of its near-death experience and appeared to be on the verge of showing positive cash flow—something not many of Wall Street’s Finest were expecting, having finally abandoned the former darling of the Telecom Bubble on the Worldcom scrap-heap.

Nextel stock looked cheap, and I requested an Excel spreadsheet from one of the larger Wall Street houses. The "model" had everything—income statement, cash flow statement, balance sheet—and more, including a very impressive bottoms-up construction of the revenue forecast, with subscriber additions, subscriber churn and “ARPU” as the Street calls it (Average Revenue Per User)… In short, everything you needed to forecast the future for Nextel.

Except for one couldn’t-be-bigger problem: the cash flow statement was entirely wrong.

During its build-out years, Nextel had accumulated huge operating losses which would shelter any forward earnings from Federal taxes up to some amount in the billions. The analyst—detailed though his spreadsheet was—had neglected to take this “NOL” into account.

What happened was this: even though the model showed Nextel generating future earnings, and even though the model's income statement included, correctly, a provision for Federal income taxes that would not be paid thanks to the large NOL, the model neglected to add back the NOL-sheltered taxes into the cash flow statement.

Consequently, one of Wall Street's Finest was understating Nextel’s future cash generation by more than a billion dollars. Hardly a rounding error.

(I figured I was missing something, so I called the firm's salesman who talked to the analyst…who agreed that the model was incorrect.)

Now, there are some truly good-to-great analysts out there who balance the poor-to-middlings.

Kurt Wulff, for example, revolutionized the way Wall Street looks at energy stocks back in the early 1980’s, demonstrating their value was reserves in the ground rather than in earnings-per-share. (Kurt is still at it and posts his research on his own web site).

More recently, and on a less grand scale, I have another nominee for one of Wall Street’s Finest, based entirely on a single piece of research written a few weeks ago by an analyst I have never actually met.The analyst is David Manthey at Robert W. Baird, and the piece he wrote was about Hughes Supply.

Hughes Supply is a good company I have followed for many years—a fairly mundane distributor of plumbing, electrical and building products that got its start supplying the contractors who built Walt Disney World in the late 1960’s. And for those paying attention to the headlines, Hughes recently agreed to sell out to Home Depot.Speculation surrounding a Home Depot-for-Hughes deal surfaced in the fall, and the stock had been bouncing around in the high-$30’s in the months following an October 31 press release stating that the board had authorized management to look at “strategic alternatives” to “maximize shareholder value.”

But most analysts, who prefer not to get too close to the line when it comes to takeover speculation, either stayed radio silent on the issue or proffered vague price targets based on theoretical deal-multiples.

Which is why Mathney’s update on January 6—brief though it was—came as such a pleasant surprise:

“We believe it is very possible that Hughes’ senior management, seeing the stock in the mid-to-upper $20s, and hearing rumors about Home Depot, decided to line up financing to take the company private.

“Doing nothing, HUG [the Hughes ticker symbol] could potentially be acquired at a much lower price, with the acquirer deriving the benefits…. By partnering with a financial buyer, management could increase equity stakes, make changes as a private enterprise, and accrue the benefits of margin enhancement. Eventual exit strategies could include a sale, break-up, or IPO.

“By announcing the process, Hughes’ board likely clears fiduciary responsibility to shareholders by seeking the highest bid from the public markets, potential acquirers, or management’s own bid.

“We believe shareholders should hold the stock, because if HUG is acquired by any entity, it would likely occur at a premium to the current price [then $37.62]…. We believe the ceiling would likely be in the $45 range or 10x 2006 [estimated] EBITDA, which would represent a similar multiple as Home Depot’s National Waterworks acquisition.”

Four days later, Hughes Supply announced it would be acquired by Home Depot for $46.50. The stock is trading for $45.72. Wall Street's Finest, indeed.

The content contained in this blog represents the opinions of Mr. Matthews. Mr. Matthews also acts as an advisor and clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews' recommendations.

6 comments:

Thanks for the informative stories. One thing I get confused by is how it's possible for the community of analysts to remain good. I expect that the best can easily find better wages and more fun jobs as fund managers.

I'd say some luck and some skill. He did a good job of calling it like a poker hand. He understands the game, and given the hand at play, he made the correct call. Sometimes you win and sometime you don't. It would've been cool to see some type of a probabilities calculation chart similar to that of ESPN's hold 'em coverage analysis... or maybe that was in his report.

Jeff,Can you comment on the degree of access that sell side analysts get to companies that is unavailable to the buy side community (given that they provide equity finance deals and broker M&A)? I find it confusing that sell side analysts will ask hardball questions during conference calls, when from an incentive standpoint it would make more sense for them to do this off-line. Perhaps the benefits of the forum setting outweigh the costs of information sharing.

"IR": The way a sell-side analyst really gets to know management is doing deals with them--whether it's an IPO or an acquisition.

In the old days--before the Bubble--there was a wall between research and banking. I knew analysts at Merrill who were very active on the banking side, but they never talked about it and never disclosed what they learned.

All that changed during the Bubble, when research and banking merged and the analysts were spoon-fed by the companies they brought public for the bankers and then "covered" for the brokers.

And that's where the abuse came in during the 1990's.

As to the "hardball questions" you say the sell-side analysts ask on conference calls--I rarely hear any hardball questions, and when they do they tend to be very apologetic about it, and rarely follow up.

The companies that do get asked hardball questions tend to be ones whose stocks have collapsed and the analysts who stayed with a "Buy" too long are upset they got bagged, so take it out on management.

Companies whose stocks are doing well mostly get the "great quarter guys" stuff, and "I just want to drill down on" nonsense, and the current fave, "How should we think about..."